Futures contracts can be used by
hedgers and by those who speculate.
Producers or buyers of a commodity of an underlying asset are able to
hedge or lock in a price at which the underlying asset can be bought or sold.

Retail traders and portfolio managers
can position themselves to potential profit by the price movement of the
underlying asset.

Futures contracts are available for a
variety of different assets. These
include stock exchange indexes, currencies and commodities.

Futures contracts which are bought and sold over exchanges
are standardized.

A futures contract is a derivative. A
derivative “derives” its value from the movement in price of another
instrument. A derivative bases its value on the changes in the price of the
instrument that it is based upon. As an example, the value of a derivative can
be linked to an instrument such as gold. Gold futures are based upon the price
of the underlying commodity gold.

“A futures contract is a legal agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future. Futures contracts are standardized to facilitate trading on a futures exchange and, depending on the underlying asset being traded, detail the quality and quantity of the commodity.” Source: Investopedia.com. Investopedia Definition of Futures

Standardized contracts have specifications such as:

the unit of measurement,

the type of settlement which can be physical or
cash,

the currency unit the contract for which it is
denominated,

the currency of the contract for which it is
quoted,

and the quality or grade of the particular
instrument (for instance the grade of oil or fuel).

Futures contacts can either be cash
settled, or may call for the physical delivery of the underlying. A retail
trader is probably not interested in delivering or receiving the physical asset
of the underlying. The retail trader is
usually more interested in securing a profit from the movement in the price of
the underlying commodity.

Some brokerages will automatically
close a futures contract before it expires.
This prevents taking physical delivery of the commodity. If you are
going to use futures contracts, please check with your brokerage to see if they
implement this practice which can protect you.

Some cash settled contracts at the CME Group are found here: CME Cash Settled Contracts. It is important for you to know whether the futures contract is settled in cash or the physical. As stated before, if you as an investor allow a futures contract to expire, you could be looking for a place to store the physical of the commodity which the contract represents.

A stock has the potential to hold its
value indefinitely. As long as the price of the stock does not go to zero,
stock will have some value. A futures contract is finite; it will expire
according to its pre-determined time. After expiration, a futures contract will
no longer retain any value.

Hedgers can use futures contracts as a method
to manage their business

At one time, futures were used primarily to
give farmers a hedge against fluctuations in the price of the product they
produced. A futures contract could give them the ability to remove some of the
price risk, due to the potential fluctuations in the value of their product.

To illustrate, let's say we have a
farmer who is a producer of corn. We also have a manufacturer who would like to
use corn to manufacture canned corn.

If you are a farmer/producer, you most
probably are worried about one thing – a drop in the value of your commodity,
which in this case is corn.

When the farmer is planting his crop,
he is concerned about the price he will get for his corn when the corn ripens
at a future date. The farmer wants to get the best price possible, so he can
create profit for his business. He runs the risk of the price of corn dropping
between the time he plants the corn and when it is harvested then brought to
market.

The farmer and the manufacturer are able to use futures to protect
themselves …

The farmer and the manufacturer enter
an agreement. The agreement is in the form of a futures contract. The farmer
wants to get 4 cents per bushel for his corn, three months in the future when
his crop will be harvested, which will allow him to make a profit. The farmer
agrees to sell his corn to the manufacturer of canned corn for 4 cents per
bushel. The manufacturer has determined buying corn today at 4 cents per
bushel, which will be available three months in the future, will net a profit
for his company.

If the price of the corn rises to 5
cents per bushel in three months, the farmer in a sense will lose 1 cent per
bushel. The farmer agreed to sell the corn for 4 cents per bushel at a specific
date. The manufacturer will be happy
because he is getting the corn for a 1 cent per bushel discount.

The manufacturer had a greater
benefit, but both parties should be happy because they should make a profit
according to their projected cost analysis. In a sense, both parties have won.

The futures contract reduced the risk
of the farmer/producer and the manufacturer because they will be able to close
the contract at the end of the three month period, at the price of 4 cents per
bushel.

Leverage and Futures

It is important to understand that trading futures is not for
everyone. Because futures are used for
speculation as well as a portfolio hedge for investors, they can carry the
potential for large losses.

Leverage allows a trader to enter a position in futures that is
worth much more than the up-front margin requirement.

Leverage is represented as a ratio. For example, let's say that the leverage on a
particular futures position is 20:1.
This means that if you have $5,000 in your trading account, you could
enter a futures position that is worth 20 times that amount, or $100,000.

Leverage makes it possible to trade larger positions. It may
appear tempting for some newer traders.
It's important to remember that leverage magnifies BOTH profits and
losses.

If you plan to trade futures, be sure to have a complete
understanding of how your broker handles the margin and leverage requirements.

Wrapping up futures contracts…

A speculator/investor can use futures
contracts to create potential profits. Speculators/investors can place educated
bets on the price of the futures contract going up or down. Most futures
contracts are exited before expiration. For instance, a buyer of a futures
contract can sell the contract before expiration so he is no longer in the
position.

Futures contracts span a wide array of different assets. For example, there is corn, wheat, coffee,
oil, gas, gold, silver, bonds, and stocks.

Hedgers can use futures to protect
themselves from future fluctuations in the price of a underlying asset. They do this by locking a specific price at a
specific time. A hedger in the futures market can have a plan to buy or sell a
commodity such as corn. The hedger will
then buy or sell a futures contract to secure and lock in a particular
price. The price at which the hedger
buys the futures contract locks in that price which protects the hedger from
rising or falling prices.

It is important to determine how much money you have to
invest. Some futures contracts require
more capital than others.

If you need to monitor your futures contract often it’s important to trade a futures contract which corresponds with the times you are available. Futures for the most part have certain times of the day when there is more activity. If you are trading a contract which is more active when you are available, it can be to your advantage. Usually there are better fills and more liquidity when there is more volume.

If you need to hedge against the volatility in the market, futures
could offer protection.

There are many strategies used by experienced traders who trade futures both for hedging and speculation. Aeromir is a great place to learn.

Dr. Daniel Lyons is a long-time friend and the creator of ExperCharts software, which I'll be using to generate signals for the ExperSignal trade alert service.

Daniel has PhDs in Cosmology and Applied Mathematics. His hand print algorithms he created many years ago have been applied to the financial markets. Daniel trades the FOREX market using 10-minute bars. He is giving me a longer time frame version that is more suitable for options trading.

Daniel limits the degrees of freedom to maintain reliability and consistency over time. ExperCharts has over 350,000 lines of C++ code already.

As you can see from the charts above, the software is very unique. The Neural Candles remove noise, which makes trend detection simple.

There are hundreds of millions of calculations every second that Daniel distills into charts, indicators and his engines. The result is a simplified view of the market in question with sophisticated tools to aid in determining if the market is turning or not.

The Trade Alert Service

Like many new things, unforeseen delays have pushed the launch of ExperSignal back. Daniel keeps getting closer to sending a fully debugged version to me so I can start the ExperSignal trade alert service.

THIS HAS NEVER BEEN TRADED BEFORE. HYPOTHETICAL PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS

The initial testing I did was VERY encouraging.

With a four-month backtest using a simple futures-only trading strategy, the test generated over $11,000 of profit using about $12,000 of margin. The biggest drawdown was -$750 with one of the two losing trades.

Daniel is including a spreadsheet with the price data and indicator values over time so I can refine what trading strategies to offer in the trade alert service.

I anticipate have several flavors of trades available:

Futures-only

Shorter-term options strategies

Longer-term options strategies

I don't have a launch date yet, as I'm waiting for Daniel to finalize the current version. It is getting much closer each day.

NOTE: After this version is sent to me, Daniel and I are going to discuss adding ES futures to ExperCharts. The software can handle it but Daniel doesn't have data for it as he only trades FOREX. The intention is definitely to add ES to ExperCharts so I can do futures and futures options strategies on ES, which has much more liquidity than the FOREX currency futures and futures options.

Pairs trading is generally considered a market neutral
strategy. Some traders use the strategy
as a directional strategy. Pairs trading
is one of many approaches a trader can use to reduce risk.

The strategy often combines a long position with a short position, using a pair of highly correlated assets. A pairs trade can use any two assets. Many times traders use assets such as two stocks, two exchange traded funds, two currencies, two commodities, two options, or two futures.

Any number of combinations can be used in pairs
trading. Some examples are the FTSE verses
the DAX, NDX against S&P 500,
FedEx vs United Parcel Service, Home
Depot vs. Lowes, etc.

Often these markets move together. A trader looks for some type of correlation
between the two assets. The two assets
will not be completely correlated. When
there is an up or bullish day, both assets generally go up in price. The same goes if there is a bearish day, both
assets will generally go down in price.

Controlling risk is very important. A pairs trade must be constructed within the
guidelines of the trader's risk tolerance.

Today’s example refers to pairs
trading as a market neutral strategy using stock.

Pairs traders using stock as the underlying asset often look
for a variation in the correlation between the two assets. A trader may elect to enter long on the asset
which they feel will rise in price. At
the same time, they will short the asset which they feel will go down in price.

In a market neutral strategy, the profit on a pairs trade is
realized from the difference in the price change between the two assets. The relationship between the two assets has
changed, resulting in a profit or loss.

Profits using stock as the underlying
asset can accrue if:

The long asset increases more than the short
asset.

The short asset decreases more than the long
asset.

The long asset goes up, and the short asset goes
down.

A pairs trader can realize a profit in many different market
climates and volatilities.

Because the strategy pairs one asset in correlation to
another asset, it reduces market exposure.
This tends to produce a hedge against market risk.

The market neutral pairs trade takes away some of the market
risk because the risk is applied to the relationship between the long and short
asset and not the overall market.

A market neutral pairs trade is not concerned with which
direction the market moves, so directional risk is less. The profit is realized
by the difference in price change between the two assets and not the market
itself.

Divergence in a Pairs Trade …

Some traders will enter a pairs trade when there is
divergence. Divergence can be caused by a big move in one asset while the other
asset does not move much in price.
Sometimes both assets will move in opposite directions which cause
divergence.

If the trade is entered on a divergence basis, the trader
would be hoping that the correlation between the two assets will revert back to
the mean.

Figure A. Chart showing the
relationship of GOOG and /NQ.

In figure A the green and red line depicts the price
movement of GOOG. The purple line
depicts the price movement of /NQ.

Divergence is the difference in the price plot of /NQ and
GOOG is indicated on the chart in Figure A.

This divergence for some traders indicates a good entry
point for a pairs trade.

The trader could enter the position with the hope that /NQ
and GOOG would revert back to the mean.

A trader can construct a directional
pairs trade.

To do this, the trader would determine the ratio between the
two assets. From the ratio, the position
can lean towards the directional bias of the trader.

For example, a trader feels XYZ stock at a price of 100, is
more bullish than ABC stock with a price of 50. XYZ stock has a 2 to 1 ratio
when compared to ABC stock. Therefore
the position is weighted bullish on XYZ stock.

How does a trader calculate the ratio
for the two pairs?

The ratio for each asset in a pairs trade is calculated by determining the notional value of each underlying asset.

The notional value is important because a trader needs to
know how much leverage is being controlled.
This is helpful in the event the trade goes against the trader. It helps to define risk.

How to determine the notional value
of a futures contract…

A futures notional value is equal to the dollar value of one
futures contract.

The future /ES $ dollar value is $50. Let’s say the current price of ES is 2800.

To calculate the notional value, multiply the dollar per
point which is 50, times the current price which is 2800. This equals the notional value of $140,000.

Pairs trades can be constructed using
stocks and futures.

Let’s use /NQ and GOOG as an example. The futures symbol for
the Nasdaq is /NQ.

Let’s say NQ is currently trading at 7180.00 and GOOG is
trading at 1166.00.

To determine an approximate 1 to 1 ratio for /NQ and GOOG, a
trader would divide 7180 by 1166. This
equals 6.15. Therefore the approximate
one to one ratio would be 1 contract of /NQ
and 6 contracts of GOOG.

1 contract: NQ = 7180.00

6 shares GOOG= 6996.00

What are Some Advantages of Pairs
Trading?

Market neutral strategy – The spread or
difference between the two assets can be traded.

The strategy can also be traded directionally.

In general there is less volatility in the
trade.

The trade can be scaled to help offset some of
the risk.

What are some Disadvantages of Pairs
Trading?

Controlling risk can be hard at times.

Margin on the trade can be high. Two assets are
being traded so there is margin on each asset.

Commissions can be costly due to two
assets.

Execution can be challenging- partial fills and
slippage can occur.

In Summary…

The subject of pairs trading is enormous. This article has given you some insight of
the world of pairs trading.

Pairs traders often look for an opportunity where the two
instruments are acting in an abnormal relationship to each other. When this relationship begins to fail, pairs
traders can buy long the instrument, which is performing weakly, and short the
instrument which is performing strongly.
Once the relationship of the two instruments returns back to its
statistical norm, the trade can be closed.

Pairs trades can also be executed directionally.

Determining the correct ratio of a pairs trade is important. From the ratio, a trader can build the
position according to the determined directional or neutral bias.

Market profile can be used by both short and long term
traders. For the most part, market
profile is based on information derived from price and volume. Market Profile compiles information from the
past and combines it with the present to help forecast the potential future. This
information is gathered and provides areas on a chart to help a trader
formulate a trading bias.

Market Profile originated in the futures industry back in the
early 1980’s. It was created by The
Chicago Board of Trade. Time, Price and
Volume are combined and shown on a chart in a statistical distribution similar
to a normal bell shaped curve. Many
traders use market profile as an essential tool to assist them to evaluate an
underlying. Market Profile can help a
trader to gain some clues for a better understanding where the value areas are
in a market.

It takes time and commitment to become a master at market
profile. As a trader becomes more
familiar with using market profile, more proficiency will be obtained. Market profile is not a market signal, but
rather allows a trader to get a feel of the context to the underlying being
evaluated.

It is a way to look at the market.
It can allow a trader to look at the market in depth. Market Profile, along with market context,
can help a trader to develop confidence in their trading. This can assist a trader to get into higher
probability of profit trades.

One method to find clues to market context can be found by
observing a higher timeframe to view the underlying, looking for the overall
trend along with support and resistance areas.
If the trend is over extended with the possibility of reversing, this
should be noted. The trader then applies
the knowledge obtained by observing the higher timeframe to the shorter term
timeframe to evaluate a potential trade.

The Bell Curve and its Relationship to Market
Profile…

The book titled “Mind Over Markets”, written by James
Dalton, defines Market Profile as “the markets activity recorded in relation to
time in a statistical bell curve”. A
bell curve according to Investopedia is “the most common type of variable, and
due to this fact, it is known as a normal distribution”.

When an instrument has high liquidity and is viewed on a Market Profile chart, the chart will often tend to resemble a bell curve on its side.

The standard deviation of a particular underlying will inform you
about the possible movement over a period of time, based on probabilities.

Let’s look at Figure A. When
the data points are all near the mean (center of the graph), then the standard
deviation is close to zero. The farther away the data points are from the mean,
the higher the standard deviation. The bell curve is a normal distribution, and
demonstrates that among a certain number of samples, there is normal outcome. These normal outcomes can be used as a tool.

Breaking this outcome
into percentages:

+1/-1 standard deviation covers 68.2% of
occurrences

+2/-2 standard deviation covers 95.4% of
occurrences

+3/-3 standard deviation covers 99.6% of
occurrences

Understanding a Market Profile Chart …

Figure B:
Market Profile Chart(Image courtesy
of marketcalls.in)

Figure B shows an example of a Market Profile Chart. The capital letter “O” indicates the Market Open
price on the chart. The “#” symbol represents
the Market Close.

Letters identify time on the Market Profile Chart. The time period labeled A is the first time
period. The first time period will
create a range and is called the Initial Balance. As the trading day continues, the information
printed on the Market Profile chart will create patterns. These patterns are called “day types.” These patterns create shapes. These shapes
and patterns are recognized by traders and often given names such as a POP
pattern, a B pattern, a shoulder pattern, P pattern, etc.

Time price opportunities or TPO’s are shown in Market Profile and
are defined by CBOTMP1 as “opportunity created by the market at a certain price
at a certain time.“ Time Price Opportunities
(TPO’s) are shown in Market Profile and represent trading activity over a time
period at particular price levels.

Volume is represented in Market Profile. It can be observed by the number of letters
which correspond to each TPO. This
offers a trader the opportunity to observe what market participants are doing
at a certain price.

The horizontal area on the Market Profile chart that has the most
Time Price Opportunities (TPO’S) is called the Point of Control. The TPO’S are represented by alphabetical
letters.

The Value Area shows the zone where 68% to 70% of the trades
occurred during the time period. The
Value Area is shown within the red bracket in Figure B.

Balanced Markets …

When price action is basically staying within certain areas or
boundaries, the market is often referred to as balanced and orderly, and those
areas or boundaries are often seen as support and resistance. Traders are playing within those areas on the
Market Profile chart.

When a trader sees those support and resistance areas where
traders are playing, the trader may use those support and resistance areas to
plan and execute a trade.

Some traders may use certain areas to execute directional
trades. Traders may see an opportunity
when price goes beyond and outside the 68% to 70% value area, towards either
the buying and selling tails(as shown in Figure B). They may choose to execute a trade thinking
price will revert back to the value area.
The value area often tends to be a magnet when price reaches the
outlying areas.

Unbalanced Markets …

When markets become unbalanced, price action will go beyond the
value area where traders were playing, a so called new play area could be
forming. A breakout of the previous
trading activity could be occurring, resulting in new areas of support and
resistance. This could form another
bell-curve or play area. A trader may
choose to place trades in this new play area.

In Summary …

Market Profile charting is a tool which can give a trader context
of the underlying market. Market Profile
is not an indicator or a trading system.
Many traders will use Market
Profile along with other tools such as moving averages, patterns and shapes, candlestick
patterns, etc..

“Tell me
and I’ll forget, show me and I may remember, involve me and I’ll understand.”

Chinese
Proverb

There are two informative books written by James Dalton, Markets In Profile and Mind Over Markets, (mentioned earlier)
which you may want to explore to learn more about Market Profile. The books teach concepts, theories and
strategies for Market Profile.

Here’s an informative video you may like to watch if you want to learn
more about Market Profile:

Night Owl is a futures day trading system that trades Crude Oil futures (CL) and Euro futures (6E). It is has roughly a 78% win rate and generates a return of approximately 5% to 6% per month. Night Owl is flat by the market close every day so there is no over night risk.

Mark has been trading professionally for over 20-years. The seeds of the Night Owl began when his mentor, a floor trader at the CME, told Mark that many floor traders use the square of nine to find significant price levels in any market.

This started Mark on a journey to master the square of nine concept. He added other techniques and rules to development his trading style that became Night Owl.